Convertible
Debt Instruments

DOWNSIDE PROTECTION

IN SPECIAL SITUATIONS

SUMMARY

Convertible debt instruments are debt arrangements, like promissory notes, that may be converted into equity of the borrower in certain circumstances.

CONVERSION TRIGGERS

Conversion is typically:

• at the election of the holder following an event of default, in an attempt to give the holder control of the borrower on a timeframe quicker than going through the courts to seize assets;

• at the election of the holder at any time when debt remains outstanding, particularly where the debt functions as emergency financing in times of liquidity pressure; and/or

• in connection with an exit event or other significant transaction, if the as-converted consideration would yield greater returns than the repayment amount.

Parties may negotiate other triggers depending on the particulars of the given funding.

RELATIONSHIP WITH OTHER DEBT

If the borrower maintains debt facilities or other indebtedness, those lenders may either block a conversion feature or require an intercreditor agreement to place additional restrictions on when it can be exercised vis-à-vis senior debt.

PITFALLS

Common pitfalls include:

• failing to require the borrower to maintain enough authorized equity at any given time should the conversion feature be exercised or triggered;

• not including an assignment provision requiring the borrower to grant equity resulting from a conversion to an affiliate of the holder, where the holder has an institutional practice of separating debt holdings from equityholdings; and

• not seeking advice from tax counsel and accountants, as convertible debt instruments may have material tax implications depending on their exact terms.

NEGOTIATING STANCE

Convertible debt instruments, or provisions in otherwise typical promissory notes that contain conversion features, are generally viewed as holder-friendly. However, conversion optionality may be appropriate depending on the particulars of a given transaction—and the parties’ overall goals.